Don’t invest in microfinance

By Felix Salmon

August 13, 2009

taking a skeptical look at the excesses of PE-funded microfinance institutions, even if the newspaper still feels the need to put the word "microfinance" in scare quotes in its headlines.
"
data-share-img=""
data-share="twitter,facebook,linkedin,reddit,google,mail"
data-share-count="false">

It’s good that the WSJ is taking a skeptical look at the excesses of PE-funded microfinance institutions, even if the newspaper still feels the need to put the word “microfinance” in scare quotes in its headlines.

I’m a fan of genuinely local, bottom-up microfinance. But what the WSJ is talking about — which is where the real growth is — is top-down microfinance, driven by external funds from the developed world. Ethical funds, in particular, love these investments, partly because they have very little correlation with any other asset class, and partly because everybody loves to think they’re investing in the next Grameen. The problem is that Grameen never took foreign money, for a very good reason.

At heart, a lot of these investments are a gussied-up carry trade. Developing-country financial institutions borrow dollars, and invest them in the local markets, with little if any currency hedging. A few organizations are beginning to offer hedging services to microfinance institutions, but such services are unlikely to prove particularly popular, because it’s that implicit FX risk which accounts for a huge proportion of these institutions’ profits. Much better that microfinance organizations grow a little more slowly, and much more organically, either by getting grants rather than loans, or by funding themselves locally.

It’s undoubtedly true that microfinance could be a lot bigger than it is now. But the way to get there from here isn’t to throw for-profit private-equity dollars at it. The real constraint is finding and training good local women who can underwrite well and who know their customers on a personal level. There’s a reason that these PE-backed microfinance dollars are concentrated in cities right now: it’s the only way to scale up quickly. But speed is the enemy of quality, as the WSJ’s Ketaki Gokhale demonstrates, and in Ramanagaram it has resulted in the local mosque successfully urging its congregation to default on all their loans, with stubborn uncooperativeness on both sides:

The mosque leaders are also demanding that lenders give them an accounting of their finances. The lenders say they’re not about to comply with that.

Any microfinance institution which so easily angers and refuses to cooperate with local religious institutions is walking on very dangerous ground. If western do-gooders want to support microfinance lenders, they should simply donate their money to grassroots organizations in the developing world. If they want to make a profit, they should stick to more conventional investments.